What is Index Options and its Types?

Last Updated: 27 Dec 2024

In the Indian options market, it is the index options that are a lot more popular and liquid. Just as a stock is an option on a stock, the index option is an option on a well-accepted index like the Nifty, Sensex, Bank Nifty, etc. What are index options and how do they work? Apart from the index options definition, let us also look at what is index options conceptually. Here is a quick take on what are index options, the types of index options, and how and when to apply the same.

Index Options and its Types

Index Options are the derivative instrument, which means their value is derived from the movements in the underlying index. In India, there are popular indexes like the Sensex, Nifty, Bank Nifty, Nifty Financial Services. Supposed you want to take a view on these indices rather than on individual stocks, you can use index options. You can also use index options to protect your portfolio by using contrary index options as a hedge.

Normally, index options are available where the futures are already available so there is a benchmark for option pricing. Then the lot sizes, strike prices, and different expiry periods are determined for the index options and once they are standardized, they are ready and all set to trade. Unlike futures which is a kind of discrete product where either the buyer gains or the seller gains, the trader in index options is a lot more asymmetric in nature. That means; the buyer of the index options only pays the premium and that also represents their maximum possible loss.

Understanding Nifty options with an example

Data Source: NSE

The above is the Nifty call options contract on a strike price of Rs.15,800 when the nifty spot value is at 15,772 in the NSE. This is a right to buy Nifty at an exercise price of Rs.15,800 without the obligation to buy. However, to get this right without the obligation is a privilege you need to pay a price. Currently, the price you need to pay for this right is Rs.54 and the price keeps constantly changing depending on the view on the Nifty future movement.

What happens if you buy the Nifty 15,800 call option at Rs.54? Nifty has a minimum lot of 75 shares of Nifty so that is the bare minimum you need to buy. So, buying one lot of Nifty 15,800 call option (right to buy at 15,800) will cost you Rs.4,050. Remember that the options contract will expire on the last Thursday of June which is 24 June. So, you have just 2 days left to close the position at a profit. In the meanwhile, if the Nifty falls sharply, you may not get anything and lose the entire Rs.4,050.

If the Nifty goes up to 15,810 on Wednesday and the Nifty option goes up to Rs.70, then you book a profit of Rs.1,200 (75×16) on the trade and walk out with a profit. Either way, your maximum loss on this index options trade can never be more than Rs.4,050. Of course, when you add up the brokerage and statutory charges, you would find that the minimum loss is higher than that but that is the whole idea.

Types of index options

Let us quickly go one step ahead and look at the types of index options. The index options classification can be done in 3 ways as under.

• Among the index options, an index call option is a right to buy the index and an index put option is a right to sell the index. The former is a bullish view while the latter is a bearish view.
• You can also classify index options as being ITM / OTM / ATM options. In the money or ITM options are the index options that are profitable if exercised. OTM options are not profitable if exercised. To simplify, if You are holding the Nifty 15,800 call option, the option is ITM if Nifty is at 15,810 but it is OTM if Nifty is at 15,790.
• Currently, Indian markets permit the trading of index options on the Nifty and Bank Nifty on a monthly and weekly options basis. The monthly options expire on the last Thursday of the month while the weekly options expire every Thursday.

Key Characteristics of Index Options

• Derivative Nature: The value of index options comes from an underlying stock market index, such as Nifty 50 or Sensex in India.
• Speculation without Ownership: They enable traders to speculate on the movement of the index without having to hold individual stocks.
• Cash Settlement: Since the underlying index cannot be delivered, index options are settled in cash at expiry.
• Call and Put Options: These are available in two forms—call options (for rising markets) and put options (for falling markets).
• Standardised Contracts: Features like expiry dates and strike prices are predetermined and standardised.
• Hedging Tool: These are widely used to hedge portfolio risks against market volatility.
• Capital Efficiency: They require lower capital compared to trading individual securities directly.

Index Options Trading

Index options trading is buying or selling options on a stock market index. Traders use these options to speculate on market trends, hedge against portfolio risks, or make strategic trades. Call options give the right to profit from an index’s increase, while put options profit when it falls.

The contracts are cash-settled at expiration based on the closing value of the index. Index options allow for flexibility because traders can use different strike prices and expiries to match their market outlook. This type of trading is popular because it has low capital requirements and effectively mitigates systematic risks.

How Does Index Options Trading In India Work?

India stock exchanges, including the NSE, host index options trading. Traders go for an index such as the Nifty 50 and choose an options contract depending on their view of the market. They can buy a call option for a bullish outlook or a put option for a bearish one. Contracts have standardised specifications, including expiry dates and strike prices.

Margins are required for selling options, while buyers pay a premium. At expiry, the contracts are cash-settled based on the index’s closing value. This structured process ensures transparency, regulatory compliance, and efficient trade execution.

Valuations of Index Options

Factors influencing the valuation of index options include the current level of the index, strike price, time to expiry, volatility, interest rates, and dividends. Theoretical values are usually calculated using pricing models such as the Black-Scholes formula. The intrinsic value is simply the difference between the current index level and the strike price, while the time value represents the remaining lifespan of the option and its possibility to be exercised before its expiration.

Volatility, especially implied volatility, is a very important factor in valuation because it reflects the expected price movements. The correct valuation helps traders make the right decisions and manage risk in their portfolios.

Index Options Strategies

Index options strategies are designed to help traders maximise returns or minimise risks depending on their market outlook.

• Traders can use directional strategies, such as buying call options for bullish expectations or put options for bearish scenarios.
• Volatility strategies, like straddles and strangles, allow traders to profit from significant market movements regardless of direction.
• Spread strategies limit risks and costs, such as the bull call spread, where a trader buys a call option and sells another at a higher strike price, or the bear put spread, which involves buying a put option and selling another at a lower strike price.
• Advanced strategies, including iron condors and butterfly spreads, combine multiple options to profit from stable or range-bound markets.

What are the Advantages of Index Options?

• Cost-Effective Market Exposure:Index options are a cost-effective means of achieving wide market exposure without holding individual stocks.
• Simplified Transactions with Cash Settlement: Cash settlement makes the process more efficient by eliminating the need for physical delivery of securities.
• Effective Risk Hedging:Index options are a great means of protecting portfolios from adverse market movements.
• High Liquidity for Efficient Execution: High liquidity ensures that trades can be executed without much hassle, even during volatile market periods.
• Strategic Flexibility:Traders can use a variety of strategies depending on the prevailing market conditions.
• Consistency with Standardised Contracts:Fixed strike prices and expiry dates ensure consistency and predictability in trading.
• Transparency and Fairness through Regulation:Regulation ensures a fair and transparent trading environment.

Frequently Asked Questions

How are Index Options Valued?

Normally, all options are valued based on a formula called the Black and Scholes method which helps you to calculate the intrinsic value of the call and put option. The formulas are available stored in the NSE website and also in the trading software so there is not much of number crunching you need to do. Just put the data and you get the output.

How volatile are Index options?

Index options are the most volatile as they are highly liquid and also popular among large traders, proprietary desks and institutions. The volatility of index options is normally calculated with a popular measure called the implied volatility or IV.

Which is better - Stock or Index Options?

The choice between stock and index options depends on your trading goals. Stock options offer specific company exposure, while index options provide broader market exposure. Index options are generally less risky as they reflect market trends, while stock options can be more volatile due to individual company performance.

How to play index options?

To trade index options, you can buy call options if you expect the market to rise or put options if you anticipate a decline. Traders can also use strategies like spreads, straddles, and strangles to manage risk and profit from market volatility or stable conditions.

How many shares are in an index option?

Index options do not represent shares of a company but rather a portion of a stock market index, such as the Nifty 50 or Sensex. The value of the option is derived from the index’s movement. Typically, index options are cash-settled based on the index’s value, not shares.